Tuesday, August 4, 2009

Commodity prices are an excellent way of keeping tabs in real time on the progress of the global economy. Copper has been leading the way, now up 124% from its lows of last year; crude oil is up 110%; the Journal of Commerce index of commodity prices is up 45%; the CRB spot commodity index (which contains no oil) is up 24%. With few exceptions, just about every commodity on the planet has risen significantly in price from its recent lows. While the almost universal rise in commodity prices might well have something to do with globally accommodative monetary policy, it must also reflect, in my opinion, a revival of global commerce and a resumption of global growth following last year's collapse.

I'm well aware that the global investment community is still heavily populated by bears. Many of the bears are awaiting the second coming of the global collapse, which they assume will be precipitated by the collapse of the Chinese economy and/or the withdrawal of Chinese government stimulus funds. Others point to the dangers of higher T-bond yields, and/or the inevitable reversal of the Fed's quantitative easing strategy. Still others fear that the heavy hand of Obama-fueled government and/or higher tax burdens will crush the private sector. And almost every day it seems, I see an article warning about the coming avalanche of home mortgage defaults and foreclosures, and commercial real estate disasters.

I think the bears underestimate, or fail to understand, the ability of markets to discount the future, and to reprice assets so that they can be redeployed more profitably. We will most likely see higher home foreclosures and increased commercial real estate defaults, but markets are well aware of this and the losses have been effectively priced in. The thing that disturbs markets is the unexpected. By last March the market had come to expect just about the worst combination of events that anyone could imagine. Since then the reality, while still painful to so many, has been much less bad than the expectations. Markets and the economy can rally even when faced with deteriorating conditions in some sectors, provided those conditions have been properly evaluated and factored into prices.

I think the bears also underestimate, or fail to understand, how much and how fast economic actors can adjust to changing circumstances. Free markets are still the rule in the global economy, and there are literally billions of people out there who are eager to work, make money, and improve their lot in life. The Chinese government may well be making some mistakes with its stimulus spending, but it's hard for me to imagine that a few hundred billion of stimulus funds could overwhelm or negate the efforts of the many hundreds of millions of Chinese—and Indian—workers who are driven by an insatiable desire to catch up to the living standards of the West, and who now have an opportunity to participate in the largest global free market ever created.

13 comments:

Love your optimism, Scott, and truly hope you are right. Can't help but notice, though, that what was left of the free markets in the 1930s couldn't overcome the government nonsense of that era.

Now we have totally unconstrained spending by government and the Fed because there isn't even the pretense that dollars mean something. If the Fed leaves interest rates near zero it could reignite all the worst speculative behaviors that we seen so much of this decade. Yes, that might mean another boom, but would give us a crisis for the history books a bit later.

Until we get a return to something closer to monetary and fiscal sanity, it's difficult to rejoice in rising prices. Lot's of people thought the housing boom was pretty nice -- until the consequences became apparent. That's what will happen this time if the Fed's program remains unchanged for a long time -- as they are promising.

Tom: I note a lot of "ifs" in your comment. You are obviously assuming that all the things that are still up in the air will come down on the wrong side. I think the market is doing the same. What if the Fed manages to withdraw liquidity in a timely fashion? What if Obama's decline in popularity keeps his hands tied? What if growing voter resentment of big government finds an outlet and changes the dynamic of Washington?

Yes, I agree that there are many uncertainties and that the actual outcome depends on decisions that are yet to be made.

What the Fed and the government have already done, however, guarantees significant capital consumption, according to Austrian theories that I believe. The only question is where the damage will show up.

The Fed has never before let loose a trillion dollars and then "withdrew" it. I think that will prove to be impossible. If they do just withdraw that much money, I think we will then get the recession that we should have already had.

A "bad" recession without zero interest rate distortions would actually be just what is needed. The markets need to adjust prices of securities, goods, salaries ... everything without the Fed interventions that guarantee the prices do not reflect market valuations.

Maybe our most fundamental disagreement, though, concerns current stock market valuations. I do not think current prices assume that all these things will come down on the wrong side. My opinion is that the market action during this rally has been based on the opposite premise -- or simply reflects trillions of dollars worth of liquidity pumped into economies all around the world.

Just as in 2003-2004, I would say our chances of normal, healthy growth in the next few years is Zero.

There's an important point to note about the Fed's liquidity additions. Almost all of the increase in reserves is still sitting unused at the Fed in the form of excess reserves. That money has never gotten into circulation, in a sense. What has happened is that the Fed has bought a lot of Treasuries and MBS, but the money that paid for them has not been used to expand the money supply. So to reverse this all the Fed needs to do is sell Treasuries and MBS. The amount they would need to sell is less than this year's budget deficit, so it's not an impossibility at all.

If you define growth to be a rising GDP you are certainly right. But when monetary inflation is unleashed, it raises the measured nominal and so-called real GDP without doing anything positive for most economic participants. Besides that, the GDP is impacted by government spending -- which also doesn't do anything positive for most people.

So, yes I agree that the GDP will rise. We might even have another 2003-2007 type boom, but if so that is nothing to celebrate or a cause for optimism -- unless you are planning to sell at the market top and move to Argentina? :-)

Your assumption is that the bears are not fully taking advantage of Fed policy as well.

On the contrary, I went long EM local, external, real return and commodities + non$ for currency exposure in April of this year. All of these bets have paid off. Do I think this is good for the US long term, not for a minute.

Timing of exit will be paramount when this ship returns to harbor in tatters.

PSYour faith in the Fed befuddles me. There is hardly any proof throughout history that they have done well at their supposed job and yet you base all of your hopes on this simple fact.

The Fed is hardly any closer to pulling out those treasuries and MBS products than I am to winning the lottery.

It is one thing to write papers about the right thing to do from the outside looking in, it is quite another when you are in the eye of the storm. Bernanke is in deep trouble and he knows it. His best bet may be to bow out now.

Kelvin: I would never expect the Baltic Dry Index to rise forever. As it is, it is still 375% above its low of last year. That is huge. And consider also that new shipping capacity has been added this year and prices are still way up.

Public: I have been an active critic of the Fed, and I think they have made some monumental errors in the past 10-15 years. I have warned that what they are doing now has a very good chance of creating higher than expected inflation. But I have also noted that to date there are no clear signs that hyperinflation or even double digit inflation is in our future.

Regardless, I continue to watch things like 1) the slope of the yield curve, 2) TIPS spreads, 3) gold, 4) commodity prices, 5) credit spreads, and 6) implied volatility. On balance these market-based indicators are pointing to higher inflation, but not super-higher inflation. I don't think that there is a reason to panic yet.

Yesterday I sent your Mid-Year Forecast Review (July 14, 2009) to my mailing list; I titled it 'Scott's Economic Predictions for '09 Right On....Contrary to the Naysayers'. One of my recipients responded with the following:

"Scott wrote: 'Growth: the economy is going to recover sooner than the market expects.'Here, I continue to disagree. Indeed, labor lags the market during a recovery but, and this is a big but, where is labor going to go? The jobs lost are for the most part, jobs permanently lost. i.e. there are no jobs to go back to. No jobs, no construction, no remodels, no new retail, no mortgage brokers, no real estate brokers, no automotive, no private sector jobs, higher taxes, no consumer spending. And those of us on pensions? The funds are broke, just like Enron was broke and all those counting on their Enron savings went broke. We will be liquidating assets, or living on retirement savings.

Please ask Scott where the employment is going to come from in the next 1, 2, 5-years."

CDLIC: The feelings expressed in the quote are typical of the despair that sets in at the bottom of a recession. I don't know exactly where the jobs are going to come from, but I do know that all the important indicators are pointing to the fact that we have seen the bottom in the business cycle.

It might help to view things in a stylized manner. Last year the threat of a collapse of the banking system caused people and businesses to stop spending suddenly, and to build up precautionary money balances. The sudden drop in demand caused inventory levels to rise. Rising inventories caused businesses to reduce orders. Reduced orders forced manufacturers to reduce production and lay off workers. Then the risk of a banking crisis declined and confidence began to reture. People started spending their precautionary balances. Demand improved. Inventories stopped rising and started declining. Businesses are now beginning to put in new orders to replenish inventories. Soon, manufacturers will begin rehiring and ramping production back up.

And I would add that funds are not broke. Equity prices have rebounded significantly from their lows. The S&P 500 is now up 50% since early March! Corporate bond prices have rebounded significantly. Global equity markets are up significantly. Household net worth has increased by trillions of dollars in the past several months. Construction is no longer falling and should be rising. Things are definitely getting better.